Investing

Exchange Traded Fund Pitfalls: Five Flaws To Avoid

By Paul Katzeff, INVESTOR'S BUSINESS DAILY10/26/2012 05:23 PM ET

Exchange traded funds provide a simple, low-cost way to access a swath of asset classes, from stocks to bonds and commodities. Or at least, that's how many investors, both pros and individuals, see them.

By and large, they're right. But not all ETFs fit that bill.

Some are costly, while others contain quirks that can lead to unexpected losses.

Here are five pitfalls to beware of:

 Contango. It sounds like a Latin dance step. It isn't. It's the term that describes an investment that holds a series of futures contracts, where near-month contracts are less expensive than contracts that expire later.

When the near-term contract is about to expire, the ETF sells it, using the proceeds to buy another contract, which because of contango is more expensive.

"Basically, an unwary investor in effect sells low and buys high, over and over," said Todd Rosenbluth, an analyst for S&P Capital IQ.

As a result, a contango environment can cause ETFs holding futures to lag their benchmark index.

An ETF that invests in a commodity, not futures, avoids the chance of locking you into a series of more expensive contracts.

The best defense against exposure to contango is to understand when it's likeliest to crop up.

Many funds that invest in commodities do so through futures contracts rather than by buying the physical commodity. "The problem is when shareholders assume an ETF invests in the underlying commodity," said Vedran Vuk, senior analyst for Casey Research. "So look at the fund's holdings."

ETF literature often describes holdings in general terms such as "natural gas" and "corn." That can look like the fund invests in the actual commodity. Read the fine print to see whether it invests instead in futures contracts.

Also, look for built-in defenses against contango. Those defenses are complex securities that are basically mirror images of the ETF's commodity indexes.

PowerShares DB Commodity Index Tracking Fund (ARCA:DBC) has a version called Optimum Yield, which aims to blunt contango's impact.

 Leverage. Buying and holding leveraged ETFs that seek double or triple the movements of underlying indexes can bring better-than-expected results — but also less-than-expected results.

The difference is mathematical. Leveraged funds commit to delivering the stated performance on a daily basis, not a week, month or year from now. A fund that doubles the percentage gain of an index will double its decline if that index falls. If an index dips one day, then rises by the same amount the next day to end at the starting price, its leveraged version will come up a bit short. The differences can be magnified over time.

PowerShares QQQ (NASDAQ:QQQ) was up 15.19% over the 12 months ended Oct. 23. ProShares Ultra QQQ (ARCA:QLD), aiming for twice the movement of QQQ each day, might have been expected to be up at least 30.38%. Instead, it was up only 27.42%.

If you hoped ProShares UltraPro QQQ (NASDAQ:TQQQ), aiming to triple QQQ's gain daily, would net a 45.6% gain, you would have actually ended up with 37.70%.

L everaged ETFs can be especially perilous if you're thinking of outfoxing other investors in a downturn by buying a leveraged short ETF in a popular index, counting on it to alchemize the index's loss into double or triple the gain.

Leverage in a fund with contango is highly risky. "A leveraged ETF with contango can suffer huge losses in a short time," Rosenbluth said.

Experts know that leveraged ETFs should be used only for short-term trading and hedging.

 Misleading names.Take ProShares Hedge Replication (ARCA:HDG). From the title, this looks like a way to get hedge-fund exposure.

That could be alluring to retail shareholders who are not income-eligible to invest in a hedge fund.

HDG seeks to mimic moves by the HFRI Fund Weighted Composite Index, reflecting 2,000 hedge funds. But HDG does not hold any hedge funds. It uses other types of assets to copy the risk and return characteristics of the index.

In effect, 66% percent of HDG's assets were in three-month Treasuries as of Oct. 24. "Those are pretty tame, very different from what some retail investors think they're getting," Casey Research's Vuk said.

Instead of the outperformance that hedge funds often boast, HDG's gain this year was 1.12% as of Oct. 24 vs. 14% for the S&P 500 and 3.37% for its multialternative peers.

 Tax issues. Look at SPDR Gold Shares (ARCA:GLD), which invests in gold. Unlike most ETFs, it is structured as a grantor trust. Gains and losses flow through to shareholders. Taxes focus on the underlying assets — in this case, gold bullion.

Shareholders are taxed at the 28% rate for gains on collectibles like gold, not the regular 15% rate on long-term capital gains.

"Avoid harm by reading the fine print in ETF literature," Vuk said.

For taxes, ETFs structured as partnerships have pros and cons. Part of their distributions is taxable income. But part is deemed return of capital, which is not taxed.

Still, you'll face taxes on imputed gains sent in the K-1 tax form, even if none were paid or reinvested. The biggest of these ETFs is $6.49 billion PowerShares DB Commodity Index Tracking ETF (ARCA:DBC).

ALPS Alerian MLP ETF (ARCA:AMLP), Global XMLP ETF (ARCA:MLPA) and Yorkville High Income MLP ETF (ARCA:YMLP) have another structural quirk. These are C corporations. They pay a 35% U.S. income tax as well as state and local income taxes. Those taxes are like huge, return-slashing expense ratios. "Many people don't understand the taxes," said Ronald Rowland, president of Capital Cities Asset Management. "They want (AMLP's) 6% yield." MLPA and YMLP debuted this year.

No other ETFs are taxed at the fund level, Rowland says. All other ETFs have a pass-through tax structure like a partnership.

 High fees. U.S. stock ETFs' average audited annual expense ratio of 0.51% is less than half the 1.37% expense ratio of U.S. stock mutual funds. But beware of the outliers.

"The lower an expense ratio, the better it is for shareholders because an expense ratio eats into an ETF's return," Rosenbluth said.

ETFs with few assets — like new ones — often have high expense ratios. Those mentioned above have less than $5 million. Both Teucrium funds' fees include nonrecurring expenses from their 2011 launches, says CEO Dale Riker.

NAGS' 2012 expense ratio is capped at 1.5%. That's what new shareholders pay, he adds. CRUD's expense ratio through nine months this year was 7.26%. Riker expects it to fall more. FactorShares' prospectus expense ratio is 0.75%.

If you come across a high-expense ETF that shows promise, look for a similar one with a lot more assets. Expenses paid by many more shareholders should result in a lower expense ratio.